IRS Proposes to Pull Rules on Domestically Controlled REIT Status, Re-Allowing More Foreign Control

The IRS on October 20 issued proposed regulations (REG-109742-25) that would withdraw 2024 final regulations that limited the eligibility of a real estate investment trust (REIT) to qualify as a “domestically controlled REIT” and thereby curtailed the common use of such structures to avoid U.S. income tax on foreign investors’ gains on sales of REIT stock.

Domestically Controlled REIT

Many private real estate partnerships hold U.S. real property through REITs. The general rule under Section 897(a)(1) and (c) is that gain to a foreign investor on the sale of a “United States real property interest” (USRPI) is treated as “effectively connected income” and, thus, is subject to U.S. income tax. For this purpose, under Section 897(c)(1) and (2), a USRPI includes stock of a “US real property holding corporation,” which generally includes a REIT that holds U.S. real property as its primary asset.

However, U.S. income tax is generally not imposed on a foreign investor’s sale of REIT stock if the REIT qualifies as a “domestically controlled REIT” (DC REIT), which includes a REIT in which less than 50% of the value of its stock was held, directly or indirectly, by foreign investors at all times during the REIT’s existence during the five-year period preceding the sale of the REIT stock. Although attribution rules are provided in several other contexts under Section 897, the statute does not define the term “directly or indirectly” for this purpose.

Structuring REITs with Foreign Investors via U.S. Corporations

It has generally been well accepted that the foreign status of a REIT’s direct and indirect owners is determined by looking through to the partners in a U.S. partnership that owns stock of the REIT.

However, the IRS ruled in PLR 200923001 that a U.S. corporation owned by foreign investors is treated as a U.S. shareholder of the REIT, i.e., there is no look-through to the foreign shareholders of the U.S. corporation. Under this approach, foreign investors could own more than 50% of the stock of a DC REIT, i.e., 49% directly and the balance indirectly through a U.S. corporation. Moreover, the favorable result in PLR 200923001 was cited with approval in the legislative history to section 322(b)(1)(A) of the Protecting Americans from Tax Hikes Act of 2015, Public Law 114-113, div. Q.

Accordingly – prior to the 2024 final regulations – the REIT structure with foreign investors owning more than 50% of REIT stock, in part indirectly through a U.S. corporation, had been adopted by many private real estate partnerships in anticipation of the U.S. income tax exemption for foreign investors’ gain on the sale of DC REIT stock.

New Rules for DC REIT Status Finalized in 2024

The IRS in April 2024 finalized rules proposed in December 2022 that would curtail eligibility for DC REIT status by requiring a look-through to the domestic or foreign status of the shareholders of a nonpublic U.S. corporation unless the U.S. corporation was owned, directly or indirectly, less than 50% by foreign shareholders (25% in the proposed rules), in which case the U.S. corporation would qualify as a domestic REIT shareholder for this purpose. The final rules also included transition relief. 

Proposed Rules Withdrawing 2024 Changes

The new proposed regulations would remove the domestic corporation look-through rule and treat all domestic C corporations as non-look-through persons in determining whether a REIT is domestically controlled, undoing the changes made in the 2024 final regulations. In proposing to withdraw the 2024 rules, the IRS cited comments regarding practical difficulties in tracing upstream ownership as well as arguments that the domestic corporation look-through rule is inconsistent with the statute and conflicts with congressional intent.

The new rules, once finalized, would apply to transactions occurring on or after October 20, 2025. However, taxpayers could choose to apply them to transactions occurring on or after April 25, 2024 (the effective date of the 2024 final regulations).